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Identifying & Using Trends

It is important to be able to recognise the overall trend for a particular stock before investing in it. In the simplest terms a share is normally within an uptrend or downtrend for at least one particular timescale (a share may also be trading in a horizontal range).﻿﻿﻿﻿﻿﻿

A steep uptrend in ASOS shares

An uptrend can be identified as when a share is, on average, for a specific period of time, moving up more than it is moving down. This is often characterised by a series of both higher lows and higher highs The result is a share price that trends upwards as shown in ASOS shares. On the chart the stock has climbed from around 1600p/share to 3859p. There is no outline for the form of an uptrend so sometimes they can be less obvious. Within this general ASOS uptrend we can actually distinguish between the various timescales that they can occur over.

The blue rectangle represents the long-term picture (1-year) whereas the red rectangle represents a small portion of this. The blue rectangle highlights how the shares can be considered to be travelling in an uptrend. During the period the shares rose by well over 100%. On a shorter time frame, during April and May 2013, the shares were stuck in a short term downtrend. As the overall movement of the shares was upward, the share price troughs are known as minor lows. Equally, the top of each upward movement is known as a minor high. The low or high becomes major when the trend is broken on a long-term timescale - in this case, the spike above 4000 would become a major high should the shares break the uptrend and start to enter a downtrend. Generally speaking, a longer trend is more significant than a shorter trend - this is partly due to positive/negative sentiment being firmly established.

Trends can sometimes be easier to see on semi-log graphs (which helps distinguish between percentage changes as opposed to raw price changes) or on candlestick charts (which shown the open, high, low and close price for a particular day in graphical form).

Using Moving Averages to spot trends

The ASOS trend is very easy to spot - the reality is that unless a share is doing remarkably well or badly, then the trends will not be as obvious. The are two principal methods you can employ to exaggerate trends and make them easier to use. These are the use of moving averages and trend channels. The former method is widely available and can easily be added to a chart with a single click. It is mathematically calculated from historical prices and is overlaid onto a share chart. the latter method requires more intuition as you have to plot it yourself. It is also more useful in gauging when to buy/sell a share compared to moving averages.
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Moving Averages for Vectura shares

Moving averages help find the general price movement for a share over a period of time. The most basic types simply take the mean share price for a period of time. They do not track the actual share price as they average out past movements and help reduce the influence of factors such as volume changes. The result is a smooth line that broadly tracks price movements. They can be plotted for a variety of timescales, but commonly used examples are the 15 day and 50 day moving averages.

The shorter time frame moving average (15 day) is more responsive to price actions as each movement has a greater impact on the average. Put simply, when a moving average is rising there is an uptrend. For Vectura a clear example is during September when the shares rose strongly by 10p. When the moving averages (MA) began to dip back in March a downtrend was in action. Some traders use moving averages to determine when they should buy and sell a share. They would buy when the shorter-term MA passes above the longer-term MA and sell when the shorter-term MA crosses below the longer-term MA.

Other types of MA also exist such as exponential MA's which place a greater emphasis to recent price action relative to older price action, and Bollinger Bands. Bollinger bands typically have a normal moving average running with a higher and lower band that are two standard deviations either side of this, thus creating a moving trend channel.

Using Trend Channels and Trend Lines to spot trends
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Downward channel in Kazakhmys shares

A trend channel refers to creating two lines that are often parallel. They are drawn onto a chart - the most difficult part of creating the channel lines is figuring out where they should follow. Ultimately though, this becomes easier with experience. Shown to the right is a candlestick chart for mining firm Kazakhyms. I have drawn in the trend channel for the shares that in this case, is a long-term formation.

To construct a trend channel the first thing to look for are the minor/major lows and highs that I alluded to earlier. The lines don't have to perfectly touch each and every low, but they should come close. The most important point is that for a trend channel to be valid, there should be at least 2 distinct points for both the upper and lower channel lines. Without this you are simply drawing an invalid line - a pointless exercise. If you only have two points, try finding a narrower channel within the big picture. The more touches there are of each channel line the better and the longer the channel is valid for, the more reliable it is.

When looking at price channels you look to buy on a breakout. Looking back at the Kazakhmys chart, in January 2012, you would look for a breach of the top channel line, but this breach should be sustained for at least 1-2 weeks. In this case, it wasn't and the share fell back into the trading channel indicating a failed breach. Alternatively, an investor may look to buy a share following the successful rebound off the lower channel line, as in September 2012. The price did not break through the lower boundary and rebounded strongly indicating price strength. Considering the high reliability of the Kazakhmys channel, technical investors would have be waiting for the breach of the lower channel in early 2013. The price broke through the lower trend line and was sustained which led to a far greater subsequent fall. Selling upon the initial breach would have saved investors over 50% in losses (from 600p). A new channel line can now be drawn, although the previous channel may be kept as the downward lines may represent future resistance levels.

Single trend line for JKX shares

Sometimes single trend lines can also be used to locate trends and make predictions. In the case of JKX Oil and Gas (shown to the right), there is a long-term downward trend in place. A change of trend would require a pattern of higher highs and higher lows to be formed. 5 trend line touches have occurred in this instance. Considering the drop the shares have already had from 300p to 55p and the fact that this trend line actually falls towards 0p sharply means that this trend is likely to be broken with no more future touches. A shallow channel/lower trend line may take its place.

A Horizontal Trend

A horizontal trend in ARM shares

On some occasions a horizontal trend may be in action although these rarely last a long period of time. They often form above a line of support or below a line of resistance. Shown to the right is a horizontal trend for ARM shares. The trend is in place for a unusually long period of time (almost 2 years) and is reliable with multiple touches either side of the central band. In this case, in June 2012 the shares dip just below the trend, but recover in July and following this they broke through the upper line of the horizontal channel. Considering the horizontal period appeared to be a period of stability following a sharp move upward from 200p, the breakout acted as a buy signal for many investors. An upward channel took hold and the shares rallied strongly by over 25%.

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